The housing market is still in dire straits, no matter how pundits spin it, and we think homebuilders, mortgage companies, and housing retailers are in for more tough times. Homebuilders in particular have low earnings quality, because they must buy land in order to continue building, and as they develop, the land they buy in the future increases because of their own improvements. Here is the investment picture for these companies:
Hovnanian Enterprises (HOV): Hovnanian is the U.S.'s 6th largest homebuilder, with about 14,500 builds per year, at an average price of $280,000. The company is dominant in New Jersey; however, that state is looking at 9.3% unemployment currently, which has stubbornly stayed high over the past 18 months.
Reviews of the company's buildings are mixed. Several lawsuits over building defects have been a thorn in Honanian's side over the last several years. Here is one example. The company has received several awards, however, for construction quality and "green" initiatives, noted here.
Going back to 2009, the company faced some steep losses in the wake of the financial crisis. Global credit markets froze, and, as a consequence, buyers of HOV homes could not access credit. HOV suffered severely, with EPS losses as steep as $16 per share in 2008 and $9.16 in 2009. Despite its financial woes last decade, Fitch rated HOV's credit "stable" earlier this spring, citing negative cash flows over the last few quarters.
In addition, the expiration of the homebuyer credit last year is not helping comparative year-over-year sales. We think the outlook for HOV is very weak. Shares are overpriced around $2 per share, and we think are headed back towards the 52-week low of $1.84.
Beazer Homes (BZH): Beazer has a large mortgage financial arm, as well as a novel pre-owned homes and a eSmart homes division. These eSmart homes use higher rated R15 and ultrahigh R38 insulation in attics, and energy and water-saver appliances and faucets. We think this is a unique selling point for buyers, but, since it is so easy to copy, it does not afford BZH any real competitive advantage.
The $250M company is also spinning its current inventory into real estate rentals. BZH launched a pre-owned homes division to hedge its bets in the homes sales and rentals markets. "Cap rates," the measure of rental values, has improved lately as home prices have come down considerably and rents have crept upwards. Former home buyers are now renters. Many of the properties in BZH's rental inventory are previously foreclosed homes and distressed sales. We think at least some portion of those will be introduced from BZH's inventory coming from its own financing arm, which has been saddled with homes for which buyers were underwater and then simply walked away. BZH has its work cut out for it.
Foreclosures have cut away a large portion of new homes sales that would go to builders like Beazer. We think shares could re-test the 52-week low of $2.99 per share soon. Shares are a short until those levels.
KB Homes (KBH): KB Homes, rated the "most admired" homebuilder in 2006 through 2009, has seen its production halved and halved again, from over 40,000 units delivered in 2005 to a low of 12,500 units delivered in 2008. That represents a drop in revenue from $9B to #3B.
Astonishingly, KBH has been able to maintain its dividend (last paid May 5, 2011) throughout the financial crisis, though it did cut the dividend rate from 25 cents per quarter to .063 cents per quarter in quarter 1 of 2009. This $900M company is still losing money. KBH posted an operating loss of $47M in the latest quarter. Earnings estimates for the quarter are negative 31 cents per share and a negative $1.74 for the year, ending November 2011. Next year's earnings are expected to be positive at 41 cents, but that number has been revised downward from 81 cents 90 days ago.
We think estimates remain too optimistic. KBH is a sell, and we think shares will re-test the 52-week low of $9.43. For now, that represents 20% downside for shorts.
Pulte Group (PHM): $2.87B Pulte is saddled with $3.41B in debt and $1.29B as a cash cushion. Given softness in home sales, we are not surprised that Pulte does not pay a dividend.
We saw one insider purchase of 50,000 shares by an officer a few months ago, around $7.00 per share. Ending March 31, Pulte posted a $47M loss, following a $193M loss in the prior quarter. The company burned through $177M in cash last quarter after $1.15B in the December quarter.
Last year, Pulte took a hit by merging Centex homes in a $3.1B merger that added $1.7B in liquidity. We think the move helped the industry constrain capacity at the margins, however PHM shareholders were diluted with a less desirable builder's shares. PHM shareholders effectively hold 68% of the combined company.
We think shares are fairly valued around $7.50 a piece, however any move above $8 per share warrants a sell. We think shares could be rangebound, subject to a few indecisive moves over the next few months.
Lennar (LEN): On June 23, 2011, LEN beat earnings expectations of 5 cents, coming in at 7 cents, with $764M in revenue relative to $646 expected. Operating margins were down to 4.4% versus 6.9% last year, and gross margins dropped to 19.4% from 20% last quarter.
Revenue figures are up 37% relative to last quarter, but compared to last year, the $764M figure is down 6%. Back in February, we saw insiders selling around $20 per share. Next quarter earnings are expected to come in at 14 cents, and $1 for the full year ending in November 2012.
That number has dropped, however, from $1.24, 90 days ago. We think estimates remain overly optimistic. LEN shares could see the 52-week low of $11.93 again, hit last August. At 18.29 per share, LEN shares are likely to see weakness throughout the year. We think the glut of foreclosures in LEN markets will swamp the company. We recommend a short for investors who are not risk-averse.
Toll Brothers (TOL): $3.5B Toll Brothers dominates the luxury homebuilder market, and, fittingly, includes landscaping and golf course work, title, and engineering consulting via ESE Consulting among its operations. The company recently bought New York City condominium land for $35.5M in a move we applaud. We think TOL got an attractive price on this reposessed land, and will be occupying itself with building an 80-unit building. In that area of Gramercy Park, units sell around $1200 per square foot.
We think the luxury segment holds more promise than other areas of residential construction. Analysts expect positive earnings of 2 cents for the year versus last year's loss of 2 cents, ending October 2011 and 2010, respectively.
For the current July 2011 quarter, analysts estimate 3 cents in earnings compared to last year's 16 cents. We think estimates are too high. TOL lost 12 cents last quarter, which was a negative earnings surprise relative to a 4 cent loss expectation. Shares will remain rangebound in our opinion, and drift below $20 apiece.
D.R. Horton (DHI): As the largest U.S. based homebuilder, $3.7B D.R. Horton has a lofty price-earnings ratio of 110 and 20 on a forward basis. DHI dominates western and southern states, where most of the U.S.'s population growth has occurred. We have not seen insiders sell since August of 2010, around $10 per share.
In its April conference call for quarter 1 results, officers cited unemployment and weak confidence in the housing market as obstacles to stemming the slide in sales. DHI continues to pay a dividend of .038 cents, after cutting it twice in 2008 when it was cut from 15 cents and then 7.5 cents, respectively.
We think DHI's future is murky. The US continues to suffer from an oversupply of unsold homes, and DHI's ability to offer incentives to move product is much reduced considering that joblessness remains stubbornly high. Household formation rates, a key driver in demand for new homes, will remain soft until the unemployment rate drops significantly from current levels. Given the policy backdrop, we do not expect any significant changes in unemployment any time soon.
Bank of America (BAC): As a mortgage operation, BAC bought Countrywide Financial in January, 2008, and inherited its mess of home loan and mortgage fraud that was being investigated by the FBI. 19% of its home loans were delinquent in 2006.
Today, nearly all of BAC's mortgage lending division's mortgages are sold in the secondary market through Fannie (FNM) and Freddie (OTCQB:FMCC), which repackages the mortgages. BAC and other lenders' dependence on the two quasi-government institutions is still enormous. Earlier this year, BAC agreed to pay approximately $3B to the entities for fraudulent mortgages issued by Countrywide.
BAC has stated that it could spend anywhere between $7 and $10B buying back faulty loans. New originations are also down due to tightened lending standards, which is a good thing for consumers and stability in the U.S. housing market; however it is not good for BAC's bottom line. In 2009 and 2010, respectively, BAC lost around $2B and $2.4B. We think BAC has not yet seen the light at the end of the tunnel in its mortgage business.
Originations will be weak, in our opinion, until the unemployment rate grinds below 7%, which may take years given the unfavorable policy backdrop that employers are facing. While bright spots exist in BAC's lines of business, mortgage lending is not one of them. BAC has fallen to our fair value estimate, around $10 per share. We think shares will remain rangebound from here. We think Citigroup (C) is in an equally large hole, however, from a valuation standpoint C shares represent a mildly better bet than BAC shares.
JP Morgan (JPM): On a valuation basis, JP Morgan is undervalued using several metrics. On a discounted cash flow basis, using a 10% cost of equity assumption, shares should sell for around $55 apiece. Shares have traded with a price-book ratio of 1.2 to 1.8 in the last decade until 2008. JPM's current price-book ties the ratio low of 0.9 in 2008. With a price-earnings ratio around 8.5, shares are at least 17% discounted compared to historic multiples between 10 in 2007, and mid- to high teens from 2005-2009. Around 12.5%, the earnings yield rivals four times that of a 30-year treasury bill.
Business has also been good, with JPM earning the top spot again in investment banking. CEO Jamie Dimon is widely perceived to have successfully navigated the perils of the latest financial crisis. With plenty of positives, a third-party might expect JPM to be nearing its 52-week high. Near $40 per share, it is closer to its 52-week low of $38. We think mortgage exposure is a key culprit. Just last week, JPM agreed to a $153M settlement with the SEC over subprime mortgage bonds. The settlement shows that JPM didn't admit wrongdoing; however, the cloud over the premise that JPM potentially misled investors persists. Now JPM is linked to the Madoff fraud, properly or not, through a lawsuit by the trustee of the Madoff recovery fund.
For investors, JPM's tentacles appear so wide that, mortgage-related fraud or not, the company (much less investors) have a clear handle on the firm's net exposures to risk.
We think more comprehendable retail and wholesale businesses via Home Depot (HD), Lowe's Home Improvement Stores (LOW), Sears (SHLD) and US Gympsum (USG) offer a much better bet for investors who want to own shares in companies with more clearly outlined risks. Whether new construction comes back now or later, consumers will be buying replacement goods at retailers for all of the housing built and financed over the last several decades.